Some random thoughts on game theory, behavioural economics, and human behaviour

Tuesday, 4 December 2012

70 years after Beveridge: Credible threats and the welfare state

It is 70 years since the
publication of the famous ‘Beveridge Report’. The report set out a revolutionary
new model for social insurance that soon led to the instigation of the National
Health Service and National Insurance. One of the more interesting ‘anniversary
events’ I came across was a program on BBC Radio 4 - ‘The State of
Welfare’; it basically assessed social insurance 70 years on from Beveridge. The
clear message I got from listening to the program was that the current system
fails to deliver a core principle of the Beveridge Report. Beveridge would not have
been impressed by all the elements of our current welfare system. So, what went
wrong?

The recommendations in the
report were based upon three principles. I’ll skip the first two and focus on
the third:‘The third principle is that social security must be achieved
by co-operation between the State and the individual. The State should offer
security for service and contribution. The State in organising security should
not stifle incentive, opportunity, responsibility; in establishing a national
minimum, it should leave room and encouragement for voluntary action by each
individual to provide more than that minimum for himself and his family.’ Our current system of social security seemingly fails this
principle. The analysis of a simple game can guide us through the main issues.

The
details of the game are sketched out in the game tree below. The game starts
with a citizen choosing whether to work hard or be a slacker; working hard
would involve working hard at school, searching for a job, being willing to do
a job that’s not very pleasant, etc. If the citizen works hard then he can
either be ‘lucky’ or ‘unlucky’; lucky would mean avoiding redundancy,
disability, discrimination etc. (Because its out of the control of the citizen
or taxpayer whether he is lucky we say that nature decides.) If the citizen
works hard and is lucky then everyone is happy. Both the citizen and taxpayer
get a payoff of 100, which you can interpret as both being 100% happy.

If the citizen works hard but
is unlucky then things are not so good. Consequently, the taxpayer needs to
decide whether she will give benefits to the citizen. If she doesn’t then the
citizen has payoff 0 – it cannot get any worse. Because of this, the taxpayer
feels guilty and so her payoff is only 50 – it’s not nice to see hard working
people destitute. If the taxpayer gives benefits then the citizen has payoff 50
and the taxpayer 80. Note that the taxpayer has to pay the benefits, so her
payoff is less than 100, but she does not feel guilty, so her payoff is more
than 50.

Clearly, it pays for the
taxpayer to give benefits to an unlucky, hard working citizen. More generally,
everyone benefits if there is a national insurance system that helps hard working
people who, through no cause of their own, fall on hard times. This is a core
principle underlying the Beveridge Report. The problem, however, is that this
insurance system, like any other, creates moral hazard. To see why we need to
know what happens if the citizen chooses to be a slacker.

If the citizen is a slacker
then no amount of luck is going to help. So, without benefits the citizen gets
0. The taxpayer feels guilty about this meaning she only gets a payoff of 70.
Note that the taxpayer feels less guilty when a slacker gets 0 than when a hard
working citizen gets 0. Even so, she feels guilty. And if you’re wondering why
she should feel guilty then let me point out the slacker’s secret weapon – he
has children. No one wants to see children going without and so our taxpayer
feels guilty to see this citizen and, more importantly, his children destitute.

If the taxpayer gives benefits
then the slacker gets 60 and the taxpayer gets 75. (A slacker on benefits is
happier than a hard working person on benefits because he did not have to work
hard.) The taxpayer is less happy giving benefits to a slacker than a hard
working citizen. Crucially, however, she will still give the benefits. She gets
payoff of 75 by giving the benefits and only 70 by not giving benefits; remember
those children. It’s emotional blackmail – but blackmail can be effective.

Why should the citizen work
hard if he can get benefits anyway? Well, the citizen does have some incentive
to work hard because the 100 he can get from working hard trumps the 60 he can
get from slacking. Everything will depend on the probability of being lucky.
Suppose the probability is p. If the citizen works hard his expected payoff is
100p + 50(1 – p) = 50 + 50p. If he’s a slacker he gets payoff 60. It pays to be
a slacker if 60 > 50 + 50p or p < 0.2. So, if the probability of being
lucky is less than 20% it pays to be a slacker. That’s moral hazard – an
unintended consequence of offering national insurance is that it lowers the
incentive to work hard.

The Beveridge Report said that
social security ‘should not stifle incentive, opportunity, responsibility’. It
seems, however, that our current system is doing exactly that. So, can we do anything about it? Most ‘solutions’ seem to
focus on changing incentives. These solutions focus on ‘making work pay’ which
puts the emphasis on the payoffs of the citizen (those highlighted blue in the
game tree below). We can increase the probability a hard working citizen is
lucky, increase the payoff to a hard working unlucky person, or decrease the
payoff to a slacker on benefits. Doing any of these three things can tip the
balance in favour of hard work.

A
‘solution’ that gets much less attention, but can solve the problem in one easy
step, is to change the payoffs of the taxpayer (those highlighted brown below).
As things stand, a threat to not pay benefits to slackers is non-credible. A
slacker knows that the taxpayer will feel guilty watching his children starve
and so he will get his benefits. If we flip things around so that not paying
benefits is credible then a slacker knows that anything other than hard work
will leave him with 0. Arguably, this is the kind of the system the U.S. has
created. It certainly looks like the kind of system that Russia has. So, can we
make it credible to give slackers no benefits?

While I said this is the easy solution – it’s
not so easy to not feel guilty about those children. It requires a change in
preferences – the taxpayer to feel less guilty about slackers having nothing –
and a change in expectations – the citizen needs to know that the threat of no
benefits is credible. Neither of these is easy to do. Note, however, that if it
can be pulled off the taxpayer never needs to feel guilty: Everyone will work
hard, and unlucky hard workers will get benefits. There will be no slackers! A
harsher social security system can, therefore, end up harming nobody. That’s a
concept that seems to be missed in the drift towards a softer welfare system which
‘rewards’ slacking.